I am a dyed-in-the-wool dividend investor, with a preference for high-yielding stocks. But I've learned the hard way that focusing on yield alone is a mistake. You need to understand a company's history and its business model before you jump aboard, or you risk being shocked by the one thing no dividend investor wants to see -- a dividend cut.
That is the concise explanation for why I'm not buying Annaly Capital Management (NLY 1.02%). For those who want more detail, here's a longer explanation.
Big dividends aren't always the best dividends
Annaly certainly has an attractive dividend yield; it's running at roughly 12.5%. The thing is, yields don't normally get that high unless there's some real risk involved. That's definitely the case here and, for me anyway, the risks far outweigh the potential reward (which history suggests could be ephemeral anyway).
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For starters, Annaly is a mortgage real estate investment trust (REIT). Unlike property-owning REITs, which have fairly simple business models (buy property, lease it), mREITs own portfolios of mortgages. Generally, this comes in the form of mortgages that have been pooled together into bond-like securities called collateralized mortgage obligations (CMOs), or something similar. In this way, it is something like a mutual fund or asset manager.
This is because CMOs trade like bonds, actively being bought and sold all day long. While physical property trades openly, too, the market is less liquid and individual properties tend to be owned by one entity for long stretches of time. CMOs are far more volatile securities.
Adding to the concern here, REITs like Annaly often use leverage to enhance returns. The REIT makes the difference between the interest it collects on its portfolio of CMOs and the financing costs it faces. The collateral for at least some of the loans mREITs get is generally the CMO portfolio itself. If the value of the portfolio falls, Annaly could have to raise cash to cover a margin call. That would probably result in selling assets during a period of market weakness, which is not the best thing to be doing.
From hypothetical to reality
Ultimately, from a business model perspective, I'm not fond of Annaly because I view its approach as high-risk. I tend to be fairly conservative, but that alone doesn't mean Annaly is a bad investment. What seals the deal is the company's dividend history.
Over the past decade, the dividend has declined by nearly 60%. Most investors prefer dividends that continuously grow to dividends that continuously get cut. And since I'm hoping to live off of the dividend income my portfolio generates someday in the not-too-distant future, I certainly don't want to fill it with serial dividend cutters.
But here's the interesting thing about Annaly: Its yield has long been in the low double digits. Dividend yield and stock price move in opposite directions, so the only way for the yield to stay high as the dividend is cut is for the stock to decline. Which is exactly what has taken place. Over the past decade, Annaly's stock price has fallen roughly 60%, too. Investors like me trying to live off of their dividend income would have suffered not only a drop in income, but a capital loss as well.
To be fair, Annaly is really a total return type of investment, which requires dividend reinvestment. Institutional investors and those focused on asset allocation might find it attractive as a way to gain exposure to mortgage debt. But that's just not what I'm looking to do. I want to own reliable dividend stocks that have the potential to increase their dividends over time. Annaly has proven it isn't built for that task.
A big yield isn't enough
High-yield dividend stocks can be a siren call for investors like me, drawing us onto the rocks as we chase lofty dividend checks. I've learned through trial and error that a high yield isn't enough, with Annaly providing a great example of why. If you are a dividend investor examining Annaly, make sure you understand what it does and the results that it has achieved on the dividend front. If you do, you'll probably want to avoid it, too.
